International-bond funds are a great way to diversify a fixed-income portfolio, but currency movements can create unnecessary volatility.
It isn't uncommon for investors to diversify their stock holdings abroad. Sure, currency fluctuations can make international equities a bit riskier than their domestic counterparts, but they do not significantly alter the risk profile. In contrast, currency risk can make international bonds significantly more volatile than U.S. bonds. For example, over the past decade, the Barclays Global Aggregate Ex USD Index was more than twice as volatile as the Barclays U.S. Aggregate Bond Index. Currency movements can dominate international-bond funds' performance in the short term. This often makes them more suitable as a bet against the U.S. dollar than as a way to share in the bond returns foreign investors enjoy. Hedging currency risk can solve this problem.
Without currency movements, international bonds have historically exhibited volatility comparable to their domestic counterparts. The hedged version of the Barclays Global Aggregate Ex USD Index only exhibited about a third of the volatility of its unhedged counterpart over the past decade. The dramatic reduction in volatility that currency hedging offers may allow conservative investors to invest abroad more comfortably and better diversify their interest-rate and credit risk.
To illustrate the benefits of currency hedging for bond funds, consider the period between Jan. 28, 2002, and March 18, 2008, when the dollar experienced a 40% decline. During this period, the returns of the unhedged-currency indexes were more than twice those of their hedged-currency counterparts. However, the unhedged-currency indexes experienced much greater volatility, which translated into less-attractive risk-adjusted performance.
If the unhedged indexes didn't offer better risk-adjusted performance when the depreciation of the dollar offered such a massive tailwind, they are unlikely to offer better risk-adjusted performance over most periods.
Currency Hedging: Bonds Versus Stocks
However, it might make more sense to leave currency risk unhedged for international stocks because currency movements contribute to a smaller portion of their total volatility. To evaluate how changes in the strength of the dollar would affect stocks' risk-adjusted returns, I compared how the hedged and unhedged versions of the MSCI All Country World, MSCI EAFE, MSCI Germany, and MSCI Japan indexes performed during years when the U.S. dollar strengthened and weakened. I further divided these periods into years where the change in the value of the dollar was small (less than 5%) and large (more than 5%). The charts below show the risk-adjusted returns for the four indexes as a function of the strength of the dollar.
- Source: Morningstar Analysts
As expected, as the dollar weakened, the unhedged-currency indexes generally provided greater risk-adjusted returns than their hedged counterparts. As we move to a stronger dollar, on average, the hedged index generally provided better risk-adjusted returns.